Stop Paying So Much Attention to Corporate Profits – They Really Aren’t That Good of an Indicator

If you're an observer or participant of financial markets for very long, you will find that you can't ignore a discussion about corporate profits and how important they are for predicting equity market returns.

The thinking is simple – If corporations ain't making a profit, you aren't making a profit.

Is that really true?

Here's a look at corporate profits from 1960 through Q2 2015 and their connection (or lack thereof) with the return in the S&P 500.

Corporate Profits, 1960 to Q2 2015

Here's at look at the entire series.

It's difficult to inspect the potential connection with the number of years.  The following sections break down the series.

Overall, just based on a visual inspection, one might come to the conclusion that corporate profits and the performance of the S&P 500 are closely related.  More inspection is needed.

Corporate Profits, 1960 to 1975

Here’s a look at the 1960 to 1975 period.

In gray are quarters when corporate profits materially deteriorated. This occurred four times over this period.

The first decline is the 1960 drop.  Interestingly, the S&P 500 only declined marginally, actually gaining value over the course of the corporate profit recession.

The next decline occurred in 1966/1967.  Over this time frame, the S&P 500 gained over 16%.

The third decline over this 15 year period occurred from 1969 to 1970.  During this period, both corporate profits and the S&P 500 materially weakened.

Lastly, the 1974 – 1975 corporate profit weakness did not show up materially in the S&P 500, with the major equity index gaining value during most of the corporate cycle.

Perhaps the most interesting note is that S&P 500 led the corporate profit declines in all four instances.  This is counter to what many market analysts assume today, presuming that the S&P 500 responds to corporate declines, not the other way around.

This observation, of course, is not always consistent across the years.

Corporate Profits, 1975 to 1990

Here's a look at the three declines that occurred from 1975 to 1990.

The first occurred started in 1981 and ended in 1982.  Over this time frame, corporate profits provided a signal, declining before the S&P 500 declined.  Mark one for conventional wisdom.

The second decline occurred from 1984 to 1986.  Over this period, corporate profits provided no signal for the S&P 500.

A very similar experience holds true for the very brief 1989 corporate profit decline.

Fascinatingly, corporate profits did not decline in the quarters after Black Tuesday.

Corporate Profits, 1990 to Q2 2015

Lastly, here's a look at the most recent years.

First, there was a brief drop in corporate profits in 1991.  The S&P 500 continued gaining value over this quarter.

The second corporate profit weakness period occurred from 1997 to 2001, a period in which corporate profits exhibited more of a sputtering weakness than a peak to valley drop.

Interestingly, during the first half the S&P 500 exploded, only to give up a large portion of its gains in the latter half of the corporate cycle.

The third experience occurred from 2006 to 2008, when, for one of the few times, corporate profits provided a signal.  Corporate profits provided a leading indication that the equity markets were probably on their way down about a year before the drop occurred.

And lastly, corporate profits dropped briefly in 2011. The S&P 500 responded at the end of the brief weakness, giving up some value.

Why the Breakdown?

The spotty connection between the two leaves open the question – why?

Lots of reasons explain the phenomenon.

Perhaps the most obvious explanation is that equities value are based on expectations, while corporate profits are what actually happened.

Other explanations include accounting changes, tax changes, industry makeup of the S&P 500, and others.

Conclusion

Overall, although spoken of with such professorial presumption among some market analysts, corporate profit aren't that great of an indicator of where the American equity markets are heading.

Since 1960, more than half of the cases have shown weak to no connection between corporate profits and returns on the S&P 500.  Interestingly, the recent "big" drop in 2008 was one where corporate profits provided a valuable indication of where the market was heading.  If history is the guide, that won't happen again.